Senate

Explanatory Memorandum

(Circulated by the authority of the Treasurer, the Hon J. B. Hockey MP)

Chapter 1 - Research and development (R & D) tax incentive - targeting access

Outline of chapter

1.1 This Bill amends the Income Tax Assessment Act 1997 (ITAA 1997) to deny access to the research and development (R & D) tax incentive for companies with aggregated assessable income of $20 billion or more for an income year. The amendment better targets the R & D tax incentive to businesses that are more likely to increase their R & D spending in response to government incentives, delivering a greater return for taxpayer funds.

1.2 All references in this chapter are to the ITAA 1997 unless otherwise specified.

Context of amendments

1.3 The R & D tax incentive replaced the previous scheme (the R & D tax concession) from 1 July 2011.

1.4 The two components of the R & D incentive are:

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a 45 per cent refundable R & D tax offset for eligible entities with a turnover of less than $20 million; and

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a non-refundable 40 per cent R & D tax offset for all other eligible entities.

1.5 On 17 February 2013, the previous government announced changes to better target the R & D tax incentive. This change would deny access to the R & D tax incentive to very large companies.

1.6 There is broad support internationally for the view that R & D spending of small firms is more responsive than that of large firms to government incentives.

1.7 The Government has committed to using the scheduled 2014 review of the R & D tax incentive to review access to R & D support, and the taxation White Paper to consider the effectiveness of existing tax incentives for innovation.

1.8 This measure was previously introduced into Parliament in Schedule 1 to the Tax Laws Amendment (2013 Measures No. 4) Bill 2013. That Bill lapsed when Parliament was prorogued before the 2013 federal election.

Summary of new law

1.9 This measure prevents an entity from claiming the R & D tax incentive if its assessable income for an income year, when aggregated with the assessable income of entities it is connected with, entities it is affiliated with and entities affiliated with it, is $20 billion or more.

1.10 Although the entity is not able to claim the R & D tax incentive, it is able to treat the R & D expenditure for tax purposes in the same way as other expenditure, for example, as a deduction.

Comparison of key features of new law and current law

Detailed explanation of new law

1.11 These amendments limit the R & D tax incentive to entities with aggregated assessable income of less than $20 billion in an income year. An entity with aggregated assessable income in excess of $20 billion treats its R & D expenditure in the same way as it treats its other expenditure, for example, as a deduction. This denies access to the R & D tax incentive for very large entities, which are less likely to engage in additional R & D in response to Government incentives. [Schedule 1, item 1, subsection 355-103(1)]

Aggregated assessable income

1.12 'Assessable income' includes the assessable components of an entity's ordinary and statutory income and is worked out by reference to the residence of the entity and the source of the income.

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Australian residents include global ordinary and statutory income in their assessable income.

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Foreign residents include only Australian sourced ordinary and statutory income (unless it is assessed on some basis other than source).

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Exempt and non-assessable non-exempt income is not included in assessable income.

1.13 If a foreign resident has a permanent establishment in Australia that is covered by a tax treaty, its assessable income includes the income which is attributable to the permanent establishment from all sources.

1.14 To determine an entity's aggregated assessable income, the entity adds together its assessable income with the assessable income of entities it is connected with, entities it is affiliated with and entities affiliated with it. The new threshold is based on the entity's aggregated assessable income so that it cannot be easily circumvented by diverting income to an associated entity or directing another entity to conduct certain activities. [Schedule 1, item 1, subsection 355-103(2)]

Example 1.1: Foreign sourced and Australian sourced income

GJP Pty Ltd is an Australian resident company that wishes to claim the R & D tax incentive. GJP earns $12 billion of assessable income in the 2013-14 income year. This includes statutory and ordinary income from both Australian and foreign sources.

CJE Pty Ltd is a wholly owned subsidiary of, and therefore connected with, GJP. CJE has assessable income from all sources of $7 billion for the 2013-14 income year. This $7 billion will be aggregated with GJPs assessable income to determine whether GJP's aggregated assessable income exceeds $20 billion for the 2013-14 income year.

GJP is expected to act in accordance with the wishes of a foreign resident company, Goji Pty Ltd, with respect to its business decisions. GJP is therefore an affiliate of Goji. Goji has $10 billion of income for the 2013-14 income year. This includes $3 billion of Australian sourced income which is assessable income in Australia, including $2 billion from trading through a permanent establishment in Australia and a $1 billion net capital gain from the sale of an Australian factory and associated land. Only the $3 billion of income that is assessable in Australia will be included in GJP's aggregated assessable income.

GJP has aggregated assessable income of

$22 billion ($12 billion + $7 billion + $3 billion) and therefore will not qualify for the R & D tax incentive.

GJP will, however, be able to claim deductions in relation to the R & D expenditure it has incurred during the relevant income year. For example, the decline in value of depreciating assets it holds may be deductible under Division 40 and some capital expenditure may be included in the cost base of an asset or be deductible under section 40-880 as 'black hole' expenditure.

1.15 An entity is an 'affiliate' of another entity in accordance with the existing definition (in section 328-130). Broadly, these are entities that can reasonably be expected to act in accordance with the wishes of the other entity. [Schedule 1, item 1, paragraphs 355-103(2)(c) and (d)]

1.16 An entity is usually 'connected with' another entity where one entity controls the other or both entities are controlled by the same entity (section 328-125). Broadly, an entity controls another entity where it has a certain level of interest (the control percentage) in the income, capital or voting power of the other entity. This connected entity test is usually used to determine whether an entity is a small business entity eligible to access special small business tax provisions. For that purpose, the control percentage is 40 per cent.

1.17 For the purposes of determining whether an entity is part of a business with aggregated assessable income of more than $20 billion, the necessary control percentage is increased from 40 per cent or more to 50 per cent or more. This reflects the circumstances where a large company controls another entity and might be able to access the relevant tax information. For the avoidance of doubt, the Bill makes it clear that the Commissioner cannot exercise the discretion to treat an entity as not controlling another entity where its shareholding in the other entity is more than 40 per cent but less than 50 per cent. [Schedule 1, item 1, subsection 355-103(4)]

1.18 An entity does not have to aggregate its assessable income with an unrelated business it is connected with only because they are both owned by a State, Territory or Commonwealth Government. However, such an entity still needs to aggregate its assessable income with entities that it is connected with for some other reason. [Schedule 1, item 1, subsection 355-103(3)]

Example 1.2: Connected entities

'Mach Co' is a company that is wholly owned by the Commonwealth. Mach Co owns a 40 per cent interest in an entity 'East Coast Co' and a 51 per cent interest in 'West Coast Co'. Mach Co also has a wholly owned subsidiary 'Central Co'. Mach Co, East Coast Co, West Coast Co and Central Co each has an assessable income of $5 billion for the 2013-14 income year.

'Icca Co' is also a company that is also wholly owned by the Commonwealth. Icca Co has assessable income of $15 billion for the 2013-14 income year. Icca Co does not need to aggregate its assessable income with the assessable income of Mach Co or Mach Co's subsidiaries because Icca Co is only connected with each of them because they are all wholly owned by the Commonwealth.

Mach Co does have to aggregate its assessable income with its wholly owned subsidiary, Central Co, and with West Coast Co (because it has more than a 50 per cent interest in West Coast Co). Mach Co does not have to aggregate its assessable income with East Coast Co or with Icca Co. Therefore, Mach Co's aggregated assessable income is $15 billion ($5 billion + $5 billion + $5 billion).

Consequential amendments

Amendment to the Industry Research and Development Act 1986

1.19 The amendment to the Industry Research and Development Act 1986 (IR & D Act 1986) ensures that the conditions for eligibility of R & D activities conducted outside Australia continue to operate as intended, following the amendments that limit access to the R & D incentive.

1.20 Since R & D entities with aggregated assessable income of $20 billion or more for an income year are excluded from claiming the R & D tax offset, section 27A of the IR & D Act 1986 does not require them to register their R & D activities for that income year with Innovation Australia. This minimises the compliance costs for those R & D entities and avoids unnecessary use of administrative resources by Innovation Australia.

1.21 Under the R & D tax incentive, one of the conditions of eligibility for R & D activities conducted outside Australia is that the overseas activities must satisfy the 'significant scientific link test' - that is, be sufficiently related to at least one Australian core R & D activity that is registered or (if conducted in a future income year) is likely to be registered. These conditions are problematic if R & D entities conduct overseas activities in income years in which they are able to claim the R & D tax incentive but conduct Australian core activities in income years when they are excluded because their aggregated assessable income exceeds $20 billion.

1.22 Accordingly, the IR & D Act 1986 is amended so that, where an R & D entity was excluded from the R & D tax incentive by the $20 billion aggregated assessable income test and conducted (but did not register) Australian core activities in that prior income year, the significant scientific link test may be satisfied. What matters is whether the Australian core activities would be reasonably likely to have been registered if the $20 billion aggregated assessable income test were disregarded. Effectively, this tests whether the activities themselves were registrable and would have been registered if the entity had applied to do so. [Schedule 1, item 2, subparagraph 28D(2)(b)(iii) of the Industry Research and Development Act 1986]

1.23 Where the Australian core activities are to be conducted in a future income year, the amendment makes it clear that Innovation Australia, in applying the significant scientific link test, does not need to consider the likelihood that an entity's aggregate assessable income might reach or exceed $20 billion for that future income year. [Schedule 1, item 2, subparagraph 28D(2)(b)(iii) of the Industry Research and Development Act 1986]

Application and transitional provisions

1.24 The measure applies to R & D entities' income years starting on or after 1 July 2013. However, in aggregating an R & D entity's assessable income, an R & D entity should include the assessable income of entities that it is connected or affiliated with, along with entities that it is an affiliate of, for the same income year, even if the corresponding income year for those entities starts before 1 July 2013. [Schedule 1, item 3]

Example 1.3 : Application

Following on from Example 1.1, GJP and CJE both have income years that start on 1 July. However, Goji has a substituted accounting period that starts on 1 January (an early balancer). Goji's 2013-14 income year therefore starts on 1 January 2013. Goji's assessable income for the period 1 January 2013 to 31 December 2013 is used to work out GJP's aggregated assessable income for the 2013-14 income year.

1.25 This application date means that the measure applies to an income year that has already started for most taxpayers. If there were a significant delay in receiving the Royal Assent, it is possible that the measure could apply to an income year that has finished. Even if the amendments do apply retrospectively, taxpayers would not be misled because the measure was exposed for public comment from 7 to 20 May 2013 and was originally introduced into Parliament on 28 June 2013, before any affected year began. This Bill merely reintroduces the measure, which lapsed when Parliament was prorogued before the 2013 federal election.

STATEMENT OF COMPATIBILITY WITH HUMAN RIGHTS

Prepared in accordance with Part 3 of the Human Rights (Parliamentary Scrutiny) Act 2011

Research and development tax incentive - targeting access

1.26 This Bill is compatible with the human rights and freedoms recognised or declared in the international instruments listed in section 3 of the Human Rights (Parliamentary Scrutiny) Act 2011.

Overview

1.27 This Bill amends the ITAA 1997 to deny access to the R & D tax incentive for companies with aggregated assessable income of $20 billion or more for an income year. The amendment better targets the R & D tax incentive to businesses that are more likely to increase their R & D spending in response to government incentives, delivering a greater return for taxpayer funds.

Human rights implications

1.28 This Bill does not engage any of the applicable rights or freedoms.

Conclusion

1.29 This Bill is compatible with human rights as it does not raise any human rights issues.

Assistant Treasurer, Senator the Hon Arthur Sinodinos AO